Regulators eye leverage cap in FX

The convulsions after the SNB’s decision to cease pegging the Swiss franc to the euro are still being felt, with regulators in Europe and Australia debating the merits of tougher controls on leverage in FX markets for retail investors.

Australia is weighing up the benefits of a cap on leverage
in FX, with Greg Medcraft, chairman of the Australian
Securities and Investments Commission (ASIC), reportedly
concerned that Australia is being "picked off" by FX brokerages
because of its tolerance of high levels of leverage.

The data suggest that there has been less than an overall
3% decline in FX trading volumes in the US

Alexandra Dobra,
Kinetic Partners

Australia is not alone. The European Securities and Markets
Authority is also looking at the issue and there is a
recognition that in Europe the Markets in Financial Instruments
Directive (Mifid) – the ruling concerned with the
protection of retail investors – has a blind spot
when it comes to FX.

Mifid was written with securities and derivatives markets in
mind, and FX does not explicitly fall under its remit. It has
therefore failed to prevent excessive leverage in FX
transactions from building up, as high as 3,000 times, brokers tell
Euromoney. In Australia, ASIC reports similar levels of
leverage in FX transactions.

Currently, ASIC limits the provision of licences to
institutions that have demonstrable business ties with
Australia, in an attempt to prevent speculation on the
Australian dollar by those outside the country with no material
onshore business. It has also limited the licensing for firms
offering excessively high amounts of leverage, without
introducing an explicit leverage cap.

While this has been an important step, it has not alone been
sufficient to stem speculation on the Australian dollar with
highly leveraged positions, especially by retail traders inside
and outside of the country.

The
concern among regulators is that any attempt to cap
leverage taken at the national or regional level will only
drive trading away to jurisdictions where no such limits exist
and where traders can therefore generate greater returns.

The US is among countries that have introduced a leverage
cap, with the US Commodity Futures Trading Commission limiting
leverage to 50 times the principal invested in 2010. Japan also
introduced a leverage cap in the same year. Although it is
difficult to draw definite conclusions, it does not seem that
New York or Tokyo have suffered a dramatic decline in liquidity
as a result.

FX should be boring

Fred Ponzo, GreySpark Partners

"The data collected from October 2010 to October 2013
suggest that there has been less than an overall 3% decline in
FX trading volumes in the US," says Alexandra Dobra, senior
associate on the regulatory consulting team at Kinetic
Partners, a financial advisory firm.

The cap did not skew behaviour in terms of instruments
traded, she adds, with the proportion of options, swaps,
forwards and spot contracts, as well as counterparty types,
remaining broadly consistent before and after the cap.

Richard Crannis, managing director of regulatory consulting
at Kinetic Partners, adds: "For the biggest financial centres
to remain attractive, they need to guarantee a safeguarded
financial environment, and investors are looking at factors
such as maturity, political stability, quality and electronic
capabilities."

Industry concerns about variations in global rules and
regulatory arbitrage are particularly acute when it comes to
leverage. If one jurisdiction applies a strict leverage cap, it
is very easy for a trader to relocate to a jurisdiction where
less draconian rules are in place to avoid the cap.

A global deal on leverage would be a big step towards
reducing overall systemic risk, but this does not look likely
any time soon.

"Although, by law, losses are capped to the amount of margin
a retail client puts in, the reality was different during the
CHF debacle," he says. "Trading was frozen, liquidity was not
available to investors wanting to cut their positions and
brokers tried to push losses in excess to the margin to their
clients."

"If it is in the press, it is in the public’s
mind," he says. "If it is in the public’s mind, it
is in the legislators’, and therefore in the
regulators’."

While retail investors already had protection via strong
customer protection provisions limiting losses, European
legislators are now thinking about whether there should be
explicit, US-style caps on leverage on the wholesale side, says
Ponzo.

Caps are unlikely to be popular, especially at first,
considering the returns that are made on highly leveraged FX
trades. Many brokers take the view their clients want the
ability to lever up their trades and are keen to allow them to
do that.

In an exclusive interview with Euromoney, broker FXCM,
which was among the worst hit by the SNB’s
decision in January, dismissed the leverage debate as
"irrelevant". Many traders would still have been wiped out,
even without leverage, due to the severity of the market moves
in January, FXCM said.

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